As the Dodd-Frank rule-making process begins in earnest, I’d like to offer some unsolicited advice to regulators, and specifically the Fed. I spent many years at a large dealer, so I have some thoughts on how an effective supervisory regime for large dealer banks needs to be structured.

Put simply: You need to get in the banks’ face. I’m deadly serious about this. First, significantly expand the dedicated supervisory teams for the dealer banks that qualify as Tier 1 FHCs. It’s not enough to have a 5-10 person supervisory team for dealer banks like JPMorgan, BofA-Merrill Lynch, Morgan Stanley, etc. The capital markets side of each of these banks has tens of thousands of employees, and hundreds of people in senior risk-taking positions. The supervisory team for each Tier 1 FHC needs to have at least 50 people. Again, I am deadly serious.

Second, and most importantly, at least half of the supervisory team needs to be on-site full-time. The CPC (“central point of contact,” who heads the supervisory team) also needs to be on-site, and should have broad information-gathering authority. In other words, the Fed should be a major presence at each dealer bank. Most of the on-site supervisors should be assigned to the Sales & Trading side of the bank, since that’s where most of the short- to medium-term risk is.

The reason for all this is simple: The banks’ trading books turn over constantly, and given how large these trading books have become (relative to the bank’s total consolidated balance sheet), the risk profile of a dealer bank can change very rapidly. It’s flat-out impossible to have a realistic, real-time understanding of the health of a dealer bank without being on-site every day — I’m not even willing to debate this point.

Supervisors need to be at the bank’s main offices — conducting rotating examinations of different business lines, independently monitoring compliance with things like the Volcker Rule, as well as simply collecting anecdotal information, both about the markets and the firm. It’s easy to dismiss anecdotal information as unreliable, but this kind of color can be incredibly useful, especially for regulators. If you only rely on fully-vetted, reportable information, and reports prepared for the board of directors, then you’re guaranteed to be hopelessly behind the curve. You’re far more likely to identify potential problems at a dealer bank, as well as potential sources of systemic risk in the markets, by simply talking to people at the bank regularly.

Traditionally, supervisors for LCBOs (large complex banking organizations) have focused a disproportionate share of their efforts on ensuring that the bank has adequate risk management systems and internal controls. Given supervisors’ limited resources in the past, I actually understand why they chose this approach. But this cannot be supervisors’ primary focus anymore. No matter how sophisticated or expensive their risk management system is, banks can always just ignore internal limits. When a profitable desk uses up all its balance sheet allocation too early in the quarter, or comes up against its risk limits, there’s a good chance the desk will be granted a waiver, or simply have its risk limits raised (“just this once,” they’ll be told, although somehow it never works out that way). Even if the bank tells its supervisors about the breached risk limits — which isn’t a given, by any means — the deed is already done. No, supervisors need to take some responsibility for monitoring compliance, and they need to do it on-site.

Now, I know what the banks’ response would be to this proposal. They would vehemently object to the higher fees they’d have to pay to the Fed to fund this supervisory expansion. They would also be particularly upset about having to give Fed supervisors office space in their main New York offices. (“Do you know how valuable this space is? We have vice presidents working in cubicles!”) And they would complain about the increased compliance costs that would be required to provide the on-site examiners with the information they need (which they would no doubt supplement with a wildly inflated estimate of said compliance costs).

Please, I beg of you, do not give these arguments the time of day. The proper response to these arguments is:

“Yeah, well, life’s tough in the aluminum siding business. Deal with it. This is the cost of being a large dealer bank with access to the Fed window. As long as you have bonus pools in the $15-20 billion range, you’re not allowed to complain about the increased fees. If you don’t like it, you should consider another line of work.”

I dug these up a while ago, but since this is the anniversary of Lehman’s failure, here, for your viewing pleasure, are the front pages of the major U.S. newspapers (the WSJ, NYT, and Washington Post) on various days of the financial crisis. I was unfortunately never able to find PDFs of the FT from the financial crisis. I also included the front page of the USA Today from September 15, 2008, because I think this post needs some comic relief.

Thursday, September 18, 2008 — A massive run on money market funds is underway after the Reserve Primary Fund “broke the buck,” WaMu puts itself up for sale in a Hail Mary, 3-month T-bills go to zero, the Libor-OIS spread spikes up 300 bps. One of the scariest days of the crisis, without question.

Here's a scary thought: Let's say the European sovereign debt crisis flares up again, and one or two Euro banks fail. (Not a bank like UBS or Deutsche Bank, but a medium-sized bank like Bank of Greece or a Landesbank.) That, in turn, causes a U.S. money market fund — many of which have large exposures to Euro banks — to "break the buck," which leads to another run on money market funds.

The Fed would be powerless to help. The Fed's emergency lending authority (the famed Section 13(3)) requires that any emergency lending facility to non-banks be approved "by the affirmative vote of not less than five members" of the Fed Board of Governors. Currently, there are only four members of the Fed board: Bernanke, Warsh, Elizabeth Duke, and Dan Tarullo. Donald Kohn retired earlier this month, and the Senate has yet to vote on Obama's three nominees (Janet Yellen, Peter Diamond, and Sarah Bloom Raskin).

While I don't expect this scenario to happen, it's certainly not out of the realm of possibility. And if it did happen, the Fed would have to sit on the sidelines and watch the carnage unfold.

I understand that Senate floor time is scarce (really, I do), but this absolutely has to be at the top of the list. Yes, I know it would be time-consuming to overcome Sen. Shelby's opposition, but you know what? Screw Shelby. This has to get done, and soon.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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